There is this common conception that debts are boring. But the last year and a half have been a whirlwind for the debt mutual funds of the country. From regulatory changes to a liquidity crisis, and from credit crisis to redemption stress; the debt fund space has seen it all. And perhaps the biggest shock came when the eighth largest AMC decided to shut down six of its debt schemes, to the anguish of over 300,000 investors. Franklin Templeton’s decision was of course shocking and has raised concerns over how the debt mutual funds are not immune to the economic slowdown that is going on.
The pain of the investors has only been prolonged with the refunding process now mired in the court of law. Gujarat high court, in its ruling, has stayed the e-voting process that is required under SEBI till at least 12 June. The court is still contemplating as to whether how the funds were wound up is illegal.
The Madras High Court is a second case, where notices have been issued to the AMC and the market regulator, to seek a report on the entire refund exercise. High net-worth individuals have filed another case in the SC, alleging malpractice, and the Delhi high court is hearing another case.
Following an initial round of frustration which was directed solely towards Franklin Templeton, the fury has now been directed towards the entire industry on social media. The new tagline that is trending on social media platforms concerning mutual funds is #MutualFundsSahiNahiHai, which means that mutual funds are not good for the investors.
The Indian debt space was supposed to be a haven. But multiple crises and now the FRanlkin fiasco is changing the entire landscape in significant ways. In just one year, the blooming credit risk fund has been reduced to less than half of its size. Credit risk funds invest 65% of their money in lower-rated bonds, and they might not be able to find investors for a foreseeable future now.
Meanwhile, fund managers have already taken a U-turn. They are now moving back to taking safer bets when they had just started testing the waters with a desire to innovate in debt.
What these shifts will mean for the economy is another puzzle altogether. Business funding in the country is completely reliant on bank credit and stands at almost 60%. Private debt instruments and corporate bonds were only beginning to get recognized, and the bank has frozen its lending again, with businesses at a standstill. Fund managers had just begun to bet on the debt of less-tapped companies. This would have led to greatly increased traceability. Because of the crisis, the industry is now going back to safer bets like super rated papers and government securities. This will not change anytime soon now, and this will in turn set back the growth of the debt fund industry by a couple of years, to say the least.
For years and years, debt funds were considered to be the poorer cousin of equity funds. The equity market continues to steal the glamour, while the debt market, despite having numerous white papers, is still called the dead market. It, therefore, does not come across as a surprise that the research on the credit risk of debt funds has taken a backseat. While equity teams with full-fledged research teams were set up on the onset of the MF boom of the country, credit assessment on debt started only after the 2008 global financial crisis. Incidentally, it was around this time that Franklin Templeton decided to get creative with its debt, and used credit research to back it. their strategy towards debt was clear. It was taking unique calls and credit risk for the sake of offering higher returns to investors. Risk on credit is when an issuer could default, which would then lead to a loss of principal as well as interest. But taking the right call would mean higher interest rates on riskier bonds, which was the reward.
Fund houses that were skeptical about this strategy lost a lot of business to the debt schemes of Franklin Templeton. Owing to pressure from their internal sales team, even they had to ultimately change gears. As a result, many AMCs rushed to take in credit risk in their fund portfolios post-2010. However, as there was a shift towards lower-rated bonds, additional pressure points started to build up too. Even a few defaults, which is after all a reasonable expectation when dealing with a credit risk pool, could set off a liquidity trap. This was large because the market for the lower-rated paper was shallow and hardly ever found any buyers.
As early as August 2015, when JPMorgan ceased the redemptions in two schemes because of a rating withdrawal of the paper of Amtek Auto, inevitable fault lines in the entire system began to become apparent. However, the sudden downgrade and default at IL&FS, which was a high-rated paper until September 2018; was the real awakening. After IL&FS, mutual fund investments in the papers of Yes Bank Ltd, Dewan Housing Finance Ltd, Essel Group companies went bad almost one after the other.
Most stakeholders understand the concept of equity, but there continues to be a lack of understanding on the credit side. Even fund managers are experts on interest rate risk and not on credit risk. A lack of expertise in determining the risk resulted in a lot of AMCs outsourcing their key functions. The judgment to invest in papers was left to rating agencies, instead of being based on internal due-diligence. And until the defective mechanisms intrinsic in the ratings blew up, the risk assessment in a lot of AMCs was a one-man department. At times, however, the equity research assessed the credit risk of debt paper, which was again a fundamentally flawed strategy. Equity is about the retained profits of the future, but debt is about continuing cash flows to be able to repay regularly. Finally, towards the end of 2018, SEBI advised firms to attempt their credit assessment instead of relying solely on credit rating agencies.
Though SEBI has directed AMCs to conduct their research to ascertain credit risk, it is not mandatory yet. As per SEBI regulations, it is still mandated that fund houses use rating agencies’ ratings to make investment decisions. Liquid funds are required to keep aside a minimum of 25% of their assets in cash and cash equivalents to be able to meet redemption pressures. But this is not mandatory for other funds.
Another huge gap lies in how SEBI has categorized funds. In October 2017, SEBI decided to re-categorize funds to reduce clutter, with the initial intent to reduce the 2,000-odd funds to just 1000. But the outcome created too many categories. In debt funds, one category is defined based on the return of investment by the bond while another set is defined by the credit profile of the paper.
SEBI has also used average duration to categorize funds, thereby offering them an escape clause. This allows funds to average both long and very short term paper and still meet the fund investment criteria.
Both, credit profile and duration of the paper, should ideally be used to categorize funds. This will help fund managers to avoid taking credit risks in funds where they are not supposed to.
The path ahead
A measure that SEBI needs to take urgently is to mandate an internal credit assessment system, which will then remove the obligation to go by the ratings of rating agencies. This could also be used as an opportunity to update provisions for the winding up of schemes. Though SEBI allows units that are being wound up to be listed, a lack of liquidity in the underlying papers renders the exit unviable for many investors.
The 1996 provision that Franklin used to wind up its schemes is pretty vague and unclear. What will happen if Franklin does not get the mandatory 50% of its share of the vote from the unitholders to be able to start the winding-up process? Will it then approach the unit holders with a fresh proposal? Or will SEBI intervene?
The investment of 300,000 investors amounting to INR 25,658 crores is at stake. Naturally, such ambiguity in law and regulations comes across as a concern. A lot has changed with India’s mutual fund's industry since the mid-1990s. It is now time for the regulator and the regulations to also wake up from their deep slumber concerning these changed realities.